Question

Your accounting department has provided your team with the statement of cash flows prepared using the indirect method. At your first meeting, some of the managers have expressed concerns about the statement’s understandability and do not view the statement as anything other than a “rearranged income statement”. The managers have requested that your team explain to them how the statement is constructed. Explain the difference between direct and indirect methods. Also, explain to your managers why an indirect method is a useful approach to reporting cash flows from operating activities.

Answer 1

Difference between direct and indirect methods of cashflow statement.

1 - Indirect method starts with Net Income and produce cash flow statement by adding non cash expenses like   depreciation, deducting non cash incomes like profit on sale of fixed assets and net adjustments between current assets and current liabilities.

Where as direct method uses only those transactions which is directly related to the cash or say only cash transactions like cash paid for expenses, to employees and to suppliers and cash received from customers.

2 - Indirect method is a kind of reconciliation that adjusts Net Income to Net Cash flow from operating activities.

Direct method straightly reports all cash receipts and cash payments from operating activities.

3 - Balance sheet items are included in the cash flow from operations for the indirect method

Balance sheet items are not included in the cash flow from operations for the direct method.

4 - Because the indirect method starts with the net income all cash and non cash transactions are taken into account while non cash transactions are ignored in the direct method.

Reasons why indirect method is much useful in reporting cash flow from operating activities.

The indirect method of cash flow statement reconciles the net income with the actual cash flows from operating activities, showing how it may be different between a company's stated profitability reported under accrual basis  and its actual cash holding position.Indirect method of preparing cash flow statement establishes a connection between income statement and the balance sheet, which helps statement readers to get a more meaningful idea about the company's financial statements.  Accounting authorities requires companies using the direct method to provide additional reconciliation schedule on net income and cash flows, where as the Indirect method itself reconcilieing net income by disclosing changes in current assets and liabilities in a simpler statement format. Under direct method companies are required to disclose cash receipts and payments separately with detailed sub categeories which will make the statement much more complex.